As I reported earlier, my phantom portfolio, the Buffoonery U.S. Portfolio, is down about 13% in Canadian dollar terms since its inception in April 2005. On the other hand, my Buffoonery Canadian Portfolio is up almost 50% compared to the index of about 30%.

What lessons are there in these two, admittedly small, portfolios?

One highlight is the value of diversification. Look at the U.S. dollar return of the U.S. side of the portfolio. Overall, the six stocks were down about 2% in the past thirteen months. Not great when compared to the market's rise of about 11%, but here's the interesting point - one of the stocks was nearly wiped out entirely! Dana Corp. plummeted about 95% due to its restated earnings and bankruptcy. That is, one-sixth of the portfolio was wiped out in a single shot. At first blush, you might think, after hearing that, that the portfolio has to be down significantly. But overall, it's only down 2% in U.S. dollar terms.

This example shows the value of diversification. Six stocks is actually a little bit too small of a sample in order to provide true diversification, and by choosing the stocks randomly it did not ensure any great degree of diversification. In fact, the six might have all been comsumer products companies, or oil companies, or financial services companies. Such a selection would provide little in the way of sector diversification, and perhaps little in the way of geographic diversification if all were U.S. based companies selling their products in the U.S. However, by managing to have a little bit of diversification in my six stocks, the portfolio as a whole avoided a major meltdown when one-sixth of its components was basically wiped out. If I had bought only that single stock, then I would have seen 95% of my portfolio wiped out!

On the other hand, look what happens when a stock really takes off. In the Buffoonery Canadian Portfolio, Falconbridge took over Noranda (one of my original picks) and now itself is the subject of a pending takeover bid by Inco. FAL is up 145% since it was chosen - my $5,000 initial investment is now worth about $12,500. That helps to raise the overall portfolio return significantly. An investment like that can more than offset one or two losers in a portfolio.

Which brings me to my second point - letting your winners run. On the downside, a stock can only go to zero and wipe out 100% of your investment. But on the upside, the return is, theoretically at least, unlimited.

In fact, if I had a simple two-stock portfolio consisting only of DCN and FAL, I would have been up by about 28% in one year despite the nearly complete loss in value of DCN. This came about simply because FAL more than doubled, and thereby more than offset the loss in DCN.

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